Move over Charles Ponzi and Bernie Madoff--China is running history's largest financial scam

China has made headlines by raising the reserve requirements for its banks repeatedly this year to a current high of 17%. The move has raised fears among global investors that Beijing might overreact and slow China’s growth enough to send the world economy reeling. But acting to raise reserve requirements has also given China’s banking regulators a reputation for foresight and prudence that contrasts favorably with the inaction of the bank regulators in many developed economies who chose to sit on their hands while asset bubbles inflated.

That reputation may not be deserved.

Requiring banks to keep more capital in reserve, rather than lending it out, means China’s banks will have less money to lend. That means fewer loans for real estate speculators and developers, for the bosses of money-losing factories, for stock market speculation by individuals and Chinese corporations.

At least in theory.

In practice, however, China’s banks have been told by the government to make almost as many new loans as in 2009, the year when everyone agrees bank lending ran amuck.

How can they do that if they have to keep more in reserve? Simple. They raise capital on China’s stock markets by selling new shares.

Here’s what brings the scams of Charles Ponzi to mind.

In the 1920s Ponzi ran a scheme that promised investors a 400% return on their money from a plan to arbitrage the difference in postal prices between Europe and the United States for international postage reply coupons. Ponzi’s plan never worked but he was able to attract a huge pool of cash from his victims by paying out big returns to early investors with money handed over by later investors. The key to Ponzi’s scheme was paying out investors’ own money to attract more investors.

In the case of China ask this question Who would buy an offering of bank shares when the government, very vocally, is cracking down on lending? And when government officials are warning daily about the dangers of bad loans in the banking system?

No one. Unless government sponsored, controlled or owned investment funds were putting up cash that promised investors huge future returns

So, for example, China’s national pension fund has invested $2.2 billion in the Agricultural Bank of China in the run up to that bank’s initial public offering. That IPO is expected to be the world’s largest ever at $30 billion. And, of course, it helps to sell shares if you can show that the government—the National Council for Social Security Fund—has put money into the bank. (The national pension fund has money invested in all of China’s largest publicly listed state-owned banks.)

After the $2.2 billion investment the pension fund will be the third largest investor in the Agricultural Bank of China.

The first two? The Ministry of Finance and China’s sovereign wealth fund.

And on the evidence they aren’t wrong. Even as China’s Shanghai stock market is suffering through a true bear market, with stocks down more than 20% from their November 2009 high, China’s IPOs have been delivering huge profits. So far in 2010 Chinese IPOs have raised $25 billion—three times more than in U.S. IPOs. In their first month of trading Chinese IPOs have gained an average of 32%.

So why wouldn’t a Chinese investor buy in an IPO from Agricultural Bank of China or a stock offer from any other Chinese bank?

Of course, investors deep down might know that at least part of these gains are coming out of government coffers, but as Charles Ponzi knew the sight of enough cash can prevent most people from acknowledging what they know to be true.

Let’s look at some numbers that explain the nature of China’s bank Ponzi scheme.

In 2009 China state-owned banks made $1.4 trillion (9.6 trillion yuan) in new loans. That blew past the initial official target of 5 trillion yuan for new loans in the year and was twice as much as banks extended in new loans in 2008.

Everybody agreed that China had a problem. The economy finished the year growing at a 10.7%. Inflation has looked like it’s getting ready for takeoff. Real estate prices climbed in April at the fastest rate ever.

So the Beijing government hit the brakes. In theory.

On May 3 the People’s Bank of China raised reserve requirements another 0.5 percentage points to 17%. The move was the central bank’s third increase in the reserve requirements in 2010. By requiring banks to keep more capital on hand rather than lend it out, the action of the People’s Bank would remove $300 billion yuan ($44 billion) from the economy, Deutsche Bank estimated at the time.

And in reaction to the run-away lending of 2009 Beijing officials ostentatiously set a lower quota for new loans in 2010. Banks would be prohibited from making any more than 7.5 trillion yuan in new loans in 2010. That was a reduction in new lending of 22% from 2009’s total.

But remember that in 2009 government-owned banks lent out twice as much money as they did in 2008. The initial new loan quota in 2008 was just 3.6 trillion yuan, the same as in 2007. Toward the end of the year Beijing raised the quota to about 5 trillion yuan.

So compared to a different benchmark the 22% reduction in the 2010 quota from 2009’s peak new loan level is actually a 50% increase from the final quota level in 2008 and a 108% increase from the original 2008 and 2007 quotas.

That “reduced,” “tightened,” and “restrictive” loan target for 2010 actually represents a huge level of new loans.

This presents two problems for China’s banks. First, they are being asked to extend a huge amount in new loans at the same time as they’re being required to reserve more capital against these loans. And, second, the runaway lending of 2009 has resulted in many banks, especially those in the rung just below the biggest-state owned banks, facing deteriorating capital ratios.

In first quarter reports filed with the Shanghai stock exchange China Citic Bank (CHBJF) , for example, showed that its capital adequacy ratio fell to 9.34% at the end of March, down from 10.14% at the end of 2009. The China Banking Regulatory Commission raised its minimum capital requirement for this class of joint-stock banks to 10% at the end of 2009.

The solution to both these problems is the same: raise more capital. One estimate is that China’s publicly traded banks will have to raise 200 billion to 300 billion yuan (or $24 billion to $44 billion) in 2010. That figure doesn’t include the $30 billion that the Agricultural Bank of China plans to raise in its IPO. At 200 billion to 300 billion yuan these banks are looking to raise nearly half of all the capital raised in the Shanghai and Shenzhen stock markets in 2009.

And banks' need for more capital won’t end with 2010. Industrial & Commercial Bank of China (IDCBY) recently estimated that China’s four big state-controlled banks that have already gone public will need to raise 480 billion yuan ($70 billion) in capital to meet regulatory requirements over the next five years.

You can expect Beijing to muster all of its considerable resources to make sure that these banks can raise the capital they need. To see what I mean take a look at the Agricultural Bank of China IPO again. Besides big investments from the national pension fund, the finance ministry, and the country’s sovereign wealth fund before the IPO, financial analysts in Shanghai and Hong Kong say that big state-owned companies such as China Life Insurance and Baosteel are likely to buy shares at the IPO.

With that kind of guarantee from state-controlled capital, you can bet that this IPO will not only go to market on schedule during what is indeed a terrible market for the shares of most of China’s companies but that it will rise in price after the first day of trading.

If I were an investor living in China I’d want a piece of this game. After all if the agency set up to be the retirement safety net for China’s workers is putting those workers’ cash into deals like this, why not take the profits now since the fund itself might not be around to pay out in the future? (And the lesson of any Ponzi scheme is that the first investors get paid and the last investors take the losses.)

Plans call for the national pension fund to double its assets under management to 2 trillion yuan within five years. That promises plenty of cash to keep the capital markets open for China’s banks.